UPDATE 1-How Morgan Stanley sank to junk pricing

June 01, 2012|Reuters

(Adds details on stock performance)

By Lauren Tara LaCapra

June 1 (Reuters) - The bond markets are treating MorganStanley like a junk-rated company, and the investmentbank's higher borrowing costs could already be putting it at adisadvantage even before an expected ratings downgrade thismonth.

Bond rating agency Moody's Investors Service has said it maycut Morgan Stanley by at least two notches in June, to just twoor three steps above junk status. Many investors see such a cutas all but certain.

Many U.S. banks are at risk of a downgrade, but ratings cutscould affect Morgan Stanley most because of the severity of thecut and because of its relatively large trading business.

Even before any downgrade, the bank is suffering in the bondmarkets. Prices for Morgan Stanley's bonds and creditderivatives have been trading at junk levels since last summer,according to Moody's Analytics. Prices moved further into thenon-investment-grade category over the past two weeks amidtroubles in Greece and other Euro zone nations.

"The numbers have changed for the worse," said Otis Casey,director of credit research at Markit. "What has driven that,obviously, is Europe. The perception is - correctly orincorrectly - that Morgan Stanley is one of the U.S. banks mostexposed to Europe's problems."

Over time, Morgan Stanley's weaker bonds will translate tohigher borrowing costs for the bank. Morgan Stanley already hashigher interest expenses relative to its assets than does chiefrival Goldman Sachs Group Inc.

Investors have been worried about the bank's exposure toEurope for months, despite the bank's disclosures indicatingthat its potential losses are limited. Its Morgan Stanley SmithBarney retail brokerage joint venture is not generating thereturns that investors had expected.

Unexpected losses at its joint venture with Mitsubishi UFJFinancial Group last year also caused concern aboutmanagement's ability to deliver more consistent trading profits.

Morgan Stanley's problems were compounded by its handling ofthe Facebook IPO - its high price and large size, andselective disclosure of an analyst's reduction of his forecastsfor the social network's revenue and earnings. Facebook sharesended regular trading at $27.72 on Friday, down 27 percent fromtheir offering price of $38.

Ratings cuts do not threaten the bank's survival but willweigh on its revenue and increase its costs, analysts said.Morgan Stanley could struggle to win certain kinds of business,such as medium-term derivatives trades, and will have to postmore collateral in those trades.

Some of the costs of being downgraded are already manifest.Larry Fink, chief executive of the money-management giantBlackrock Inc, said in an interview with the New YorkTimes in April that his firm has no choice but to shift businessto higher-rated institutions when banks are downgraded.

In a May 7 securities filing, Morgan Stanley said it mighthave to post $7.2 billion worth of additional collateral andtermination payments in the event of a downgrade to Baa2, thesecond lowest investment-grade rating, up from a $6.5 billionestimate it provided three months earlier.

But bond markets are not waiting for a downgrade. On Friday,it would have cost Morgan Stanley 1.20 percentage points more toraise five-year debt than its chief rival, Goldman Sachs GroupInc. The bank would even have to pay a little more thanmuch-smaller competitor Jefferies Group.

"The Street is pretty efficient and is really moving aheadof the ratings agencies," said Carret Asset Management'sGraybill. "It's never good in this business to have adisadvantage against a strong competitor."

Given the difficulties associated with a ratings cut, MorganStanley executives are lobbying Moody's to keep the bank'srating at current levels. Standard & Poor's and Fitch have notoutlined plans for similar ratings cuts. S&P downgraded MorganStanley to A- in November, putting it four notches above junk.Fitch rates the company one notch higher, at A.

Morgan Stanley Chief Executive James Gorman has met withMoody's officials since the agency said in February it mightdowngrade the bank, hoping to persuade the agency against athree-notch downgrade.

"The kind of company we are now from a few years ago, it'svery, very different, and part of the discovery process withMoody's is to share that information," Gorman said in a CNBCappearance on Thursday.